IDEA OF CAPPING BANK SIZE The best way for Senate Dems and the White House to respond

to the Republican charge that the Dem plan for financial reform doesnt go far enough to prevent another bailout is to call their bluff and simultaneously do whats necessary to avoid another bailout: Cap the size of big banks, as the UK is close to doing for its big banks. The so-called resolution mechanism the Dems are pushing to wind down any big bank that gets into trouble is a step in the right direction. But it wont work if two or more giant banks are endangered at the same time which is likely to be the case when the next crisis occurs because every big bank uses whatever profitable financial ploys every other bank uses (as they did in the runup to the crash of 2008). Furthermore, as Ive noted before, as long as the big banks are allowed to be huge and become even bigger, their political clout in Washington will remain huge and become even bigger. And as long as they have this kind of clout, theyll wangle a bailout from Washington the next time their bets get them into trouble regardless of any resolution authority. So the Dem bill must cut the big banks down to size. The limit should be $100 billion in assets. Banks complain that their global competitiveness will suffer if theyre held to this size. Baloney. No one has been able to show any competitive efficiencies above $100 billion in assets. And for Wall Street to suggest its global competitiveness is somehow tied to the competitiveness of the rest of the American economy is the height of hubris anyway. Wall Street is making deals all over the world (i.e. Goldman Sachs and Greece), its parking its money all over the world, its star employees reside all over the globe, and it invests wherever it can get the best deals all over the world. The only competitive advantage to being a giant bank headquartered on Wall Street is to have the economic and political clout to get bailed out by American taxpayers when the next crisis hits. We have learned this once. We do not need to learn it again. Repeat: The only sure way to ensure that no bank becomes too big to fail is to make sure no bank is too big

REASON WHY CAPPING BANK SIZE IS A BAD IDEA In addition to being a jaw-droppingly superficial idea overall, heres another reason why breaking up the banks and capping their size would be a titanic mistake. Everyone seems to agree that normal, non-TBTF banks can be resolved without causing a meltdown in financial markets. This is, in fact, the justification given for capping bank size it would make all banks small enough to be resolved smoothly, which means that no single bank failure would pose systemic risks. Mission accomplished! Of course, this argument quickly breaks down when you think for more than 15 minutes about how the FDIC resolves failed banks. The FDIC resolves the vast majority of failed banks through whats known as purchase and assumption agreements, or P&As. P&As are transactions in which a healthy bank purchases some or all of the assets of a failed bank and assumes some or all of the liabilities, including all insured deposits. P&As are much less disruptive to both communities and financial markets than straight deposit-payoffs by the FDIC. The FDIC has used P&As to resolve 163 of the 187 failed banks since the beginning of 2008. The JPMorgan/Bear Stearns deal was also a form of P&A (which was entirely intentional), with the Fed playing the role of the FDIC.

Now imagine that we cap bank size at, say, $100bn in assets. What happens if a bank with $99bn in assets fails? The way the FDIC resolves failed banks smoothly is through P&As, but the only banks big enough to buy the $99bn failed bank would surely be over the $100bn cap if they agreed to the purchase. So the choice is effectively between (1) a disorderly liquidation by the FDIC, which would pose exactly the kind of systemic risks that proponents of capping bank size are trying to avoid; or (2) granting an acquiring bank (or banks) a waiver from the $100bn cap and proceeding with a P&A. (The FDIC could technically use a conservatorship, but these are extremely rare, and no regulator has the capacity to manage a $99bn conservatorship.) But think about how potential acquiring banks would respond if the FDIC approached them and offered them a waiver on the $100bn cap in exchange for agreeing to a P&A. They would think: Well, the government begged JPMorgan to buy Bear and begged BofA to buy Merrill, but then the government turned around and forced JPM and BofA to break themselves up a few years later! So thanks but no thanks, Sheila, were not interested in buying a bank that youre just going to force us to divest in a couple years. So with a cap on bank size, P&As would likely be off-the-table for the largest bank failures. But if the FDIC cant use P&As, then it cant ensure that the largest banks will be resolved smoothlyand thus pose no systemic riskseven with a cap on bank size in place! And if the FDIC cant ensure that the failure of the largest banks wont pose systemic risks, then what was the point of the cap on bank size in the first place? See how easy it is to knock down this silly break up the banks idea

IN THE WORLD OF BANKING DOES SIZE MATTERS??

It was bound to happen. After pouring tens of billions of dollars, pounds and euros: as much as 5.5 per cent of the GDP of advanced economies, according to the International Monetary Fund, governments began to revolt. If a bank is too big to fail, then it is too big, the governor of the central bank of Belgium told a newspaper at the end of June. If this is true, then what about the corollary: Small is beautiful? If bankers bonuses are being capped, should the size of their banks be capped as well? INSEAD Professor of Banking and Finance Jean Dermine thinks not. And he has some 25 years of research to back it up. There are two arguments against capping the size of banks, he says. The first is, in order to have the economy of scale in the financial sector to service large domestic corporate clients, you must have a large international bank. The Netherlands have Unilever and Shell, for example, and these companies do business around the world. The second major argument is that if you cut the size of banks they will not be diversified properly. A good example of this is in Spain, where the Cajas, or domestic savings banks, suffered massively from the real estate crisis, and many are close to default. You compare these to Banco Santander who is active in the US, the UK, Latin America (and) you see they have done much better in the crisis because they are diversified. In fact, Dermine points out that small banks in trouble are not necessarily less of a problem than their larger counterparts, and the bank equity to home country GDP ratio can be somewhat distorting: the equity of CS is 11 per cent of Swiss GDP; the Royal Bank of Scotland is 5 per cent of UK GDP, while Citibank is 0.8 per cent of US GDP.

When you look at the data, Dermine says of his research, you see that even countries with small banks have large bailout costs. Greece and the United States have many small banks affected at the same time, and the bailout cost was very, very large. Foreign currency lending risks proved to be another threat to bank capitalisation. Dermines research shows that many banks in Eastern Europe lend as much as 70-80 per cent of their portfolios in foreign currency. In the short term, profits outweighed the risks. For example, as interest rates in Switzerland are lower, the cost of borrowing is lower, until the system starts to crumble and the home currency plummets. This creates systemic risk, says Dermine. Why did banking regulators allow the risk of lending in foreign currencies? Ill tell you: because in a booming economy, there is no pressure on regulators to stop this lending in foreign currencies. A regulator would have to be very brave to tell bankers we should stop making these loans; we should stop taking these risks. Another reason for such foolhardiness, says Dermine, is a basic assumption on the part of bankers worldwide. Over the past 20 years, many bank managers felt governments and central banks wouldnt let banks go into default. They thought the view was that banks shouldnt be allowed to fail, and this created a major moral hazard. That view ended abruptly when the US Treasury allowed the venerable 159-year-old investment bank Lehman Brothers to fail on September 15, 2008. The idea was to teach the market a lesson, says Dermine of the massive meltdown. They had helped JPMorgan take over Bear Stearns a few months earlier, then a few months go by and Lehman Brothers is in trouble. But they knew that putting Lehman into default would not put other major institutions into default. And indeed, international banks have been able to meet the losses linked to their exposure to Lehman. Maybe not, but banks were scared witless by the collapse of Lehman Brothers. Bankers wondered if Lehman was allowed to default, were they going to see other institutions put into default? There was a massive collapse of confidence and bankers absolutely refused to lend to each other. That created a liquidity crisis and that was the start of the banking crisis. Dermine wants to see improved regulation rather than capping bank size as a way of containing financial fiascos in the future. In a service economy, banks provide a lot of highly-skilled jobs, and we believe it would be the wrong policy to reduce the size of these banks. In the last 10 to 15 years, mathematical advances have allowed better measurement of credit risk, and this led to an explosion of financial products related to credit. The point is, weve taken on too much risk. Dermine favours an idea thats being discussed today in the US and the UK which would create special bankruptcy rules for banks: regulators would shut the bank for the weekend and force the conversion of debt into shares, which would substantially increase the banks amount of equity when it reopened Monday morning. Additionally, Dermine would like to see independence and accountability of supervisory agencies, with banking regulation independent of politics; a prompt and corrective action mechanism; a burden-sharing system so that bailout costs are shared by a group of countries, and an end to the too-big-to-fail doctrine, replaced by new bankruptcy rules as outlined above. Indeed, the shape of the post-crisis financial world supports Dermines belief that banking regulation, rather than a cap on bank size, is the way to prevent another meltdown. The major outcome of the crisis is that some banks are much bigger today. In the case of America, Bank of America has merged with Merrill Lynch, it has bought Countrywide. In the UK, Lloyds TSB has become much bigger. BNP Paribas in France purchased Fortis. These are all coming out of the crisis as much bigger institutions. Believing regulators will be better able to manage these and institutions tomorrow without significant changes; I dont think thats going to be the case.

THE LEHMAN BROTHERS MELT DOWN (EXAMPLE FOR BANK SIZE) On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman's demise also made it the largest victim, of the U.S.subprime mortgage-induced financial crisis that swept through global financial markets in 2008. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time. (For more information on the subprime meltdown, read Who Is To Blame For The Subprime Crisis?) The History of Lehman Brothers Lehman Brothers had humble origins, tracing its roots back to a small general store that was founded by German immigrant Henry Lehman in Montgomery, Alabama, in 1844. In 1850, Henry Lehman and his brothers, Emanuel and Mayer, founded Lehman Brothers. While the firm prospered over the following decades as the U.S. economy grew into an international powerhouse, Lehman had to contend with plenty of challenges over the years. Lehman survived them all the railroad bankruptcies of the 1800s, the Great Depression of the 1930s, two world wars, a capital shortage when it was spun off by American Express in 1994, and the Long Term Capital Management collapse and Russian debt default of 1998. However, despite its ability to survive past disasters, the collapse of the U.S. housing market ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step. (To learn more about previous financial disasters, be sure to check out our Crashes Special Feature.) The Prime Culprit In 2003 and 2004, with the U.S. housing boom (read, bubble) well under way, Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans (made to borrowers without full documentation). Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion. (Check out the answer to our frequently asked question What is a subprime mortgage? to learn more about these loans.) Lehman's Colossal Miscalculation In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization of close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. In the post-earnings conference call, Lehman's chief financial officer (CFO) said that the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings. He also said that he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the U.S. economy. The Beginning of the End As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge

funds, Lehman's stock fell sharply. During that month, the company eliminated 2,500 mortgage-related jobs and shut down its BNC unit. In addition, it also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market. In 2007, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85-billion portfolio, or four times its shareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance. (Read more in Dissecting The Bear Stearns Hedge Fund Collapse.) Hurtling Toward Failure Lehman's high degree of leverage - the ratio of total assets to shareholders equity - was 31 in 2007, and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market conditions. On March 17, 2008, following the near-collapse of Bear Stearns - the second-largest underwriter of mortgage-backed securities - Lehman shares fell as much as 48% on concern it would be the next Wall Street firm to fail. Confidence in the company returned to some extent in April, after it raised $4 billion through an issue of preferred stock that was convertible into Lehman shares at a 32% premium to its price at the time. However, the stock resumed its decline as hedge fund managers began questioning the valuation of Lehman's mortgage portfolio. On June 9, Lehman announced a second-quarter loss of $2.8 billion, its first loss since being spun off by American Express, and reported that it had raised another $6 billion from investors. The firm also said that it had boosted its liquidity pool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to about 25. (Read Hedge Fund Failures Illuminate Leverage Pitfalls to learn more about the double-edged sword of leverage.) Too Little, Too Late However, these measures were perceived as being too little, too late. Over the summer, Lehman's management made unsuccessful overtures to a number of potential partners. The stock plunged 77% in the first week of September 2008, amid plummeting equity markets worldwide, as investors questioned CEO Richard Fuld's plan to keep the firm independent by selling part of its asset management unit and spinning off commercial real estate assets. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on September 9, as the state-owned South Korean bank put talks on hold. The news was a deathblow to Lehman, leading to a 45% plunge in the stock and a 66% spike in credit-default swaps on the company's debt. The company's hedge fund clients began pulling out, while its short-term creditors cut credit lines. On September 10, Lehman pre-announced dismal fiscal third-quarter results that underscored the fragility of its financial position. The firm reported a loss of $3.9 billion, including a write-downof $5.6 billion, and also announced a sweeping strategic restructuring of its businesses. The same day, Moody's Investor Service announced that it was reviewing Lehman's credit ratings, and also said that Lehman would have to sell a majority stake to a strategic partner in order to avoid a rating downgrade. These developments led to a 42% plunge in the stock on September 11. With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Last-ditch efforts over the weekend of September 13 between Lehman, Barclays PLC and Bank of America, aimed at facilitating a takeover of Lehman, were unsuccessful. On Monday September 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on September 12.

Conclusion Lehman's collapse roiled global financial markets for weeks, given the size of the company and its status as a major player in the U.S. and internationally. Many questioned the U.S. government's decision to let Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan Chase) in March 2008. Lehman's bankruptcy led to more than $46 billion of its market value being wiped out. Its collapse also served as the catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal that was also announced on September 15.

SUB PRIME MORTGAGE

Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the instance of subprime mortgage woes, there is no single entity or individual to point the finger at. Instead, this mess is a collective creation of the world's central banks, homeowners, lenders, credit rating agencies and underwriters, and investors. Let's investigate. The Mess The economy was at risk of a deep recession after the dotcom bubble burst in early 2000; this situation was compounded by the September 11 terrorist attacks that followed in 2001. In response, central banks around the world tried to stimulate the economy. They created capital liquidity through a reduction in interest rates. In turn, investors sought higher returns through riskier investments. Lenders took on greater risks too, and approved subprime mortgage loans to borrowers with poor credit. Consumer demand drove the housing bubble to all-time highs in the summer of 2005, which ultimately collapsed in August of 2006. (For an in-depth discussion of these events, see The Fuel That Fed The Subprime Meltdown.) The end result of these key events was increased foreclosure activity, large lenders and hedge funds declaring bankruptcy, and fears regarding further decreases in economic growth and consumer spending. So who's to blame? Let's take a look at the key players. Biggest Culprit: The Lenders Most of the blame should be pointed at the mortgage originators (lenders) for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default. (To learn more about subprime lending, see Subprime Is Often Subpar.) When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns. In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments. As you can see in Figure 1, subprime mortgage originations grew from $173 billion in

2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a clear relationship between the liquidity following September 11, 2001, and subprime loan originations; lenders were clearly willing and able to provide borrowers with the necessary funds to purchase a home.

Figure 1
Note: The data presented herein are believed to be reliable but have not been independently verified. Any such information may be incomplete or condensed. Partner In Crime: Homebuyers While we're on the topic of lenders, we should also mention the home buyers. Many were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages) that offered low introductory rates and minimal initial costs such as "no down payment". Their hope lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in other spending. However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly. (To learn more, read Why Housing Market Bubbles Pop.) As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgage at higher rates, which many could not afford. Many homeowners were simply forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007. In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may have given the impression that there was no risk to these mortgages and that the costs weren't that high; however, at the end of the day, many borrowers simply assumed mortgages they couldn't reasonably afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable. (To learn about moral debate surrounding all things subprime, read Subprime Lending: Helping Hand Or Underhanded?) Exacerbating the situation, lenders and investors of securities backed by these defaulting mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left with property that was worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy. Investment Banks Worsen the Situation

The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more. The snowball began to build momentum. (For a crash course on the secondary mortgage market, check out Behind The Scenes Of Your Mortgage.) A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs. The chart below demonstrates the incredible increase in global CDOs issues in 2006.

Image courtesy Hammond Associates. The data presented herein are believed to be reliable but have not been independently verified. Any such information may be incomplete or condensed.

Figure 2
Rating Agencies: Possible Conflict of Interest A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. (To learn more on the ratings system, see What Is A Corporate Credit Rating?) Moreover, some have pointed to the conflict of interest between rating agencies, which receive fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not rated.

Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market demand. Fuel to the Fire: Investor Behavior Just as the homeowners are to blame for their purchases gone wrong, much of the blame also must be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums over Treasury bonds. These enticingly low rates are what ultimately led to such huge demand for subprime loans. Much of the blame here lies with investors because it is up to individuals to perform due diligence on their investments and make appropriate expectations. Investors failed in this by taking the 'AAA' CDO ratings at face value. Final Culprit: Hedge Funds Another party that added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem. (To learn more. check out Taking A Look Behind Hedge Funds.) To illustrate, there is a type of hedge fund strategy that can be best described as "credit arbitrage". It involves purchasing subprime bonds on credit and hedging these positions with credit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs. Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls. (For more on this, see Massive Hedge Fund Failures and Losing The Amaranth Gamble.) Plenty of Blame to Go Around Overall, it was a mix of factors and participants that precipitated the current subprime mess. Ultimately, though, human behavior and greed drove the demand, supply and the investor appetite for these types of loans. Hindsight is always 20/20, and it is now obvious that there was a lack of wisdom on the part of many. However, there are countless examples of markets lacking wisdom, most recently the dotcom bubble and ensuing "irrational exuberance" on the part of investors. It seems to be a fact of life that investors will always extrapolate current conditions too far into the future - good, bad or ugly.